Private Equity: Out of the woods yet?
A report on the 18th Annual Private Equity Conference at Columbia University
by George Selinsky
On Friday February 3rd, thanks to the initiative of my fellow classmate Justin Karr, I got a chance to be a part of over 750 business students, alumni, and industry professionals who attended Columbia University’s 18th annual Private Equity conference. Leveraged buyout and venture capital firms which focused on both domestic and emerging markets were represented. The impressive selection of speakers included industry pioneers David Rubenstein (cofounder, Carlyle Group) and Joseph L. Rice (founder, Clayton, Dublier, and Rice), Robert Nardelli, currently with Cerberus Capital Management and former CEO of Home Depot and Chrysler, and the father of viral marketing, Timothy C. Draper, the VC who helped bring you Hotmail, Skype, and Ebay.
The private equity market, or investment in non-publically traded stocks and debt, has experienced an interesting ride since the global financial crisis along with the public markets, hence the name of the conference: “Out of the Storm but Not Out of the Woods” The picture is certainly happier than when I attended Stern’s private equity conference in 2009, but by no means have we returned to the pre-crisis glory days.
As many conference participants noted, the business is being thrown a new set of challenges. The vengeful voices of the ‘99%’ are demanding an increase in taxes on private equity managers, who had traditionally had their compensation taxed as long term capital gains. Newt Gingrich’s mud-slinging campaign at Mitt Romney, aiming to equate PE investing with Gordon Gekko’s breaking up and selling off of Bluestar Airlines, is adding some fuel to the fire. All of this means less money for everyone in the buy side: fund managers and their employees.
David Rubenstein (who once worked in Washington) noted that the net gain of the proposed tax reform for PE compensation would be approximately $8 billion, as compared to the $25 trillion of debt. In other words, taxing the pants off of general partners (fund managers) is not likely to be the magic bullet which will stop the growing budget deficit.
The problem appears to be that the PE industry has simply not presented a strong case of its value proposition to the public, although current economic conditions and public sentiment make it a particular challenge for the PE industry to sway hearts and minds. Robert Nardelli underlined that while some deals may not work out and are forced to liquidate, retaining productive human capital is highly desirable – the efficiencies bought about in a buyout operation often end up saving jobs, not destroying them.
Adding more heat to the PE business is pressure from the limited partners (PE fund investors) to lower the fees. LPs these days are trying to get GP compensation down from the traditional 2% to 1% of AUM.
During the conference’s Middle Market panel, the participants underlined that the usual customers of private equity investment firms – pension funds, insurance firms, and endowments – are also screening manager’s performance with greater scrutiny before investing in the fund as a limited partner.
GPs are being asked by prospective LPs to go deal by deal, explaining how they got their returns in the past. It is worth pointing out that this approach is becoming more and more common in financial services in general, e.g. hedge fund managers must go through a similar process. In reality, there is a reason for the scrutiny: sometimes a fund manager can simply get lucky. Haven’t we all heard of the day trader of the tech bubble era?
By the same token, in crisis there is often opportunity as well. The abysmally low yields offered by today’s fixed income market, an asset class which portfolio managers have relied on to produce steady diversified gains, forces them to ‘chase yield’ in private equity. Emerging markets such as Brazil, Africa, India, and Russia can offer strong returns that are not possible in developed economies. Businesses throughout the world are in need of private capital, be it a tech startup in the Valley or a pharmaceutical firm in Africa. The PE world certainly has a future.
General Industry Trends
A very large percent of private equity firms do leveraged buyouts, and the majority of private equity money is deployed in this area. Years ago, leveraged buyouts were primarily conceived of by many fund managers as pure financial engineering. The LBO was pretty much a leveraged trade – you took the company private with debt ratios as high as 95%, and after some operational tweaks, cashed in like a king.
These days, leverage levels have been drastically tightened thanks to the credit crisis. Consequently, many managers have been forced to rely on leverage as low as 40% or less. One manager reported how his fund decided to acquire a firm with very little leverage, since a major bank had pulled its debt financing. Fortunately, the acquisition was made exactly as the equities market bottomed in March of 2009. Thereon after as the firm value grew, the fund had managed to increase leverage temporarily to boost its return before reversing course to harvest the value.
As a consequence of reduced leverage levels, the main theme for LBO managers has become intensely targeted improvement in operations, the true heart of the LBO’s value. This means getting deeply involved with managing the firm. Justin Hillenbrand of Monomoy has his associates attend an ‘operations boot camp’, where they go in and work with the portfolio company for several weeks in order to get an intimate feel for the firm’s operations. Robert Nardelli of Cerberus follows a similar tactic, allowing employees to move from the fund to the portfolio firms and back.
Emerging Market Trends
Emerging markets, once the blue ocean haven of PE fund managers, have now become a more crowded space in the more well known emerging markets nations and regions such as China, South America, India, and Africa. Nonetheless, opportunities abound and fund managers continue to seek extraordinary returns in these areas while exploring newer territory. Timothy Draper’s VC fund, Draper Fisher Jurvetson, is invested globally in countries such as Russia and Israel, looking for the next game changing technology. Some emerging market opportunities are so lucrative that PE managers like Thando Mhlabiso of Allen Grey are contemplating using investment holding companies in the future as investment vehicles to avoid the forced exits inherent in a limited partnership.
An important question for any GP to answer is whether PE opportunities have considerably higher return potential than publicly traded stocks. Sebastian Villa of Southern Cross noted that in Brazil, there are many hybrid funds that invest in both the public markets and private firms to reap advantages on both sides. The question comes down to whether PE firms can not only identify the right deals, but add the value necessary to make the company grow.
Addressing this point, Mukul Gulati of Zephyr Management discussed minority middle market investments in India where opportunities abound in industries such as pharmaceuticals. Many entrepreneurs need PE expertise in order to scale their model and achieve higher growth. The challenge with minority investments often comes down to striking a deal which gives the PE firm sufficient control in major strategic decision making, as well as conducting a very thorough due diligence process on the entrepreneur.
This process can be quite complicated in emerging markets, as Mhlabiso indicated. For example, in certain African countries, there are ‘business clans’ which are as strong as families in their loyalty to one another. Having such clan members on a board can introduce an agency conflict, and it is not always easy learning about who is a clan member on the board of your portfolio firm. Keeping your own people ‘on the ground’ in the country you are investing in is a crucial element of success. Fund managers such as Rubenstein will only hire locals for their emerging markets operations.
On the positive side, there are not only opportunities for investment but good government support for PE as well. Government incentives, such as the South African government’s support of black businesses, are making it easier for PE firms to invest and find debt financing. There are some solid and inexpensive government sources of debt in South America as well, in some cases as low as 3-4% in countries like Brazil (at cost to board supervision, usually) – though higher rates up to the teens are not unusual either, according to Karin Koifmann of Kirkland & Ellis LLP.
Exits remain a tricky game in emerging market PE, as capital markets in these countries are still poorly developed as compared to the exchanges in the developed markets. Although managers such as Villa prefer to have the option for dual exits to capital markets as well as strategic corporate partners, the latter remains the most common way to harvest the value.
Barriers to Entry
The private equity business is a tough one to break into. This business is exciting (co-creating and reshaping entire businesses is pretty stimulating), and also has the potential for high upside. Many people are competing to manage a limited pool of capital. Consequently, private equity managers have many talented people knocking at their door with impressive resumes, and they can afford to be choosy.
Traditionally, only graduates of the top three business schools (U Penn Wharton, Harvard, and Stanford) have been recruited directly from graduation into the major ‘megafund’ PE firms such as KKR. Others must make it through various avenues, such as investment banking, management consulting, or through the ‘operations’ side (actually running a firm). That said, the panelists offered some ideas about whom they like to hire for these highly coveted spots.
Smart people are definitely important, but not ‘too smart’ as one speaker commented, as those candidates may be a bit too hard to manage (so if you’ve got that one A- that spoiled your 4.0, take heart!). An “energetic achiever” is a commonly desired characteristic for front office finance positions and is especially critical in a business like PE, where all-nighters in Excel are the norm, not the exception. Another key attribute in a successful hire is ‘fit’. As PE firms are considerably smaller in size than investment banking divisions, there is a lot more interaction with senior people. They better like you if you’re going to be around them all day and all night!
Rubenstein mentioned that hiring practices have become more diverse; there is a shift away from the ‘Caucasian male educated in the east coast ivies’ mold. A diversity in educational background was emphasized by one middle market GP, in an age where specialization has become in vogue.
Some division of opinion occurred over how entrepreneurial potential hires should be. PE is an entrepreneurial business by its nature, as is trading. At the same time, the growth in size of PE firms (in particular, the massive size of mega LBO funds) means the environment is getting somewhat less entrepreneurial than in the past, as Rubenstein opined. Another risk that hiring managers face is the reality that individuals who are highly entrepreneurial may simply bail out after a few years of learning and start their own funds. Not all fund managers were averse to this idea, seeing it as a normal part of the business. And if I dare speculate, this shouldn’t come as a surprise, after all many of them probably did the same thing!
In conclusion, despite the threats of heavy taxation, regulation, and tighter credit conditions, PE managers are certainly not ready to throw in the towel (this annual conference had its highest turnout ever this year). Opportunities for investment continue to exist domestically and abroad, and institutional portfolio managers need the yield and diversification that PE can provide. Once economic conditions stabilize, perhaps the public will take a break from its irrational witch hunt, while legislators will shift their focus from appeasing the mob to encouraging investment. We all like our jobs, and our i-phones, but we often forget that these things are possible in part due to the infusion of private capital into private and public enterprises.
If you’re a Baruchian and have an interest in private equity, I highly recommend taking FIN 9774, Venture Capital and Entrepreneurial Finance, as taught by Raj Nahata. Professor Nahata assigns a variety of interesting cases which teach both the qualitative and quantitative (valuation) components of a PE deal. In addition to covering “classic VC” cases, venture leasing, LBO, and rollup/M&A cases are provided as well, covering a variety of industries.